Financial Flows and Money Markets

Economics 71a

Spring 2007

Mayo, chapter 1

Lecture notes 2.1

Outline

Finance fundamentals Investment characteristics

Term Liquidity Return Risk States of nature

Money connections Interest rates

Finance Fundamentals and Functions

Firms

Consumers

Savings

Invest Payout

Return

Time

Finance Fundamentals and Functions

Firms

Consumers

Savings

Invest Payout

Return

Time

Intermediaries/Financial Service Firms

Finance Fundamentals and Functions

Consumers

Consumers

Savings

Borrow Repay loans

Return

Time

Intermediaries/Financial Service Firms

Investment Characteristics

Term Length of time

Liquidity Ease of buying and selling

Return Risk States of nature

Money Connections

Money Store of value Transaction medium Unit of account

Monetary Instruments(High to Low Liquidity)

Cash Debit cards Checking accounts Money market accounts Government bonds Much less liquid (Are these money?)

U.S. Stocks Corporate bonds Gold

Credit Cards

What are they? Not a store of value Not an investment

Roles Transactions Borrowing

Interest Rates

Key price for many financial instruments

Interest Rate Units

Usually in percentage termsExample

Annual interest rate = 8% Time period here = 1 year Lenders lending $100 get $108 in 1 year Borrowers getting $100 loan, pay back

$108 in 1 year

Real Interest Rates

Nominal rate of interest Rate before inflation adjustment

Real rate of interest Rate after adjusting for inflation

More later

Interest Rate Determination

D = demand for loans

InterestRate

Quantity of loans

S = lender supply

What happens when the economy “heats up”

D = demand for loans

InterestRate

Quantity of loans

S = lender supply

Shifts in Demand and Supply for Loans and Savings

During good times Firms increase demand for loans People probably increase demands for

loans Interest rate rises

What about personal savings? Less clear

Shifts in Demand and Supply for Loans and Savings

Government Borrowing The government is a major player too If it increases or decreases its borrowing

the demand for loans will change

Different Interest Rates

Rates vary over Time (maturities) Risk

Probability of default

Time: The Term Structure

Different rates for different horizons 6 month 1 year 2 years 5 years 10 years 30 years

Yield Curve

1 2 5 10 20

Years into futureTime of maturity

Interest RateAnnual %

5%

The Yield Curve

The yield curve changes over timeSee “The living yield curve” Inverted yield curvesThe yield curve and GDP

Risk/Return Tradeoff

Return

Risk

U.S. Stocks

U.S. Corporate Bonds

U.S.Government Bonds

EmergingMarketStocks

Outline

Finance fundamentals Investment characteristics

Term Liquidity Return Risk States of nature

Money connections Interest rates